The Federal Reserve is about to begin to shrink its massive balance sheet. Officials say the process is running in the background, but it will not happen. Investors need to have uncertainty and volatility in the long run.
When the central bank released its minutes from its March meeting last week, it suggested in May that it would begin to split a few trillion dollars in epidemic bond purchases it had made over the past two years. It will be lightning fast and that level of relaxation is now complete. The Fed last held tight or QT, waiting two years after interest rates were raised to shrink its balance sheet. Its newly proposed plan would be tantamount to doubling the policy tightness – half of which investors may have lost.
We know that if Russia had not invaded Ukraine, policymakers would have raised rates by half a point in March, and meeting minutes and the latest Fedspeak many officials expect at least a 0.5% increase in future meetings. According to CME data, traders have an 80% chance of a half-point hike in May and a 50% chance of another in June.
But Peter Bouquar, chief investment officer at Flickly Advisory Group, says prices are not close to QT markets.
It makes sense that there is more focus on rates than on balance reduction. While economists, market analysts and corporate executives can easily model for interest-rate changes, QT has only happened once before. Also, as Bougainville points out, it happened at glacier speed. Investors have new details on how the Fed handles its $ 9 trillion portfolio – which has doubled since the outbreak and accounted for about 40% of GDP – but it is unclear how it will fare in the economy and markets.
As Federal Reserve Chairman Jerome Powell said earlier this year, “I think we have a better sense of the fact that rate hikes are affecting financial conditions and therefore economic conditions. [The] Balance is still relatively new to markets and to us, so we are less optimistic about it.
Here’s what we know so far: The central bank has cut $ 60 billion in its reserve coffers and $ 35 billion a month in mortgage-backed securities, signaling that it will accelerate in three months. This will replace the maturing securities instead of reinvesting.
On the treasury side of the portfolio, it’s very easy, at least next year or so. Bougainville notes that one-fifth of the central bank’s treasury will mature in $ 5.8 trillion in a year or less, and about 30% of that piece will mature in three months. According to Barry Knob, director of research at Ironcides Macroeconomics, about $ 4 trillion in bank deposits and another two trillion in cash have been frozen at the central bank, meaning it will take at least a year to absorb the excess cash.
This is very tricky on the mortgage support securities page. Part of the problem: as rates rise, advances fall. This extends the tenure of the central bank’s MBS holding and restricts short-term natural flow. As of November 2021, the conditional down payment rate was approximately 30%, according to data provided by S&P Global. Jefferies chief economist Aneta Markovska says the MBS runoff would average $ 20 billion a month if foreclosures slowed to 10%, as it did at the height of the 2017-19 tight cycle. It is well below the $ 35 billion signaled by the Federal Reserve, and will need to sell about $ 15 billion a month in mortgage support to achieve its goal.
Not long ago, the idea that the central bank would sell MBS was shocking. Now, Wall Street thinks direct sales will not happen until 2023; It will be very soon, says Bougainville.
What else do we know about QT? When rates directly touch demand, quantitative operations directly affect property prices. QE has raised those prices significantly since the central bank’s acquisition, and investors should expect a balanced outcome with QT, although the central bank will not completely change its contagious purchases. Bougainville says that every $ 1 trillion in QT equals 0.5% of the extra tightness. But how much will stock and home prices fall? No one knows.
Here are some things to keep in mind:
When the central bank sells MBS, there will be buyers, including banks, insurance companies and pension funds, says Joseph Wang, a former senior trader at the central bank’s open market desk. But he notes that over the next several years, about $ 2 trillion in Qt is going to merge with the historically high treasury output. I.e. the greater the distribution that investors can absorb before the MBS sale. Moreover, Wang adds, recent financial flows indicate that demand for treasuries is declining. “Even the most eager bond bulls will not have enough money to absorb the flood of output, so prices should fall to attract new buyers,” he observes. So, how far should prices fall and how much should yields rise?
Then there is the impact on housing. How the central bank handles the MBS split is important for what is happening to the economy as a whole. The central bank should cool the housing market, which accounts for 40% of consumer price inflation and one-fifth of GDP. But what happens when demand falls, but prices still rise due to lower inventory?
Finally, when the central bank sells MBS, it is likely to do so at a significant loss. Who will eat it?
Last week the central bank released more QT details than many strategists expected. But because investors and policymakers are together in the dark, there are more questions than answers.
Write to Lisa Beilfuss at email@example.com